In 2014, the IRS released guidance to taxpayers informing them that cryptocurrency transactions, which the agency refers to as virtual currency transactions, must be reported on income tax returns. Because cryptocurrency is a new frontier for many, we’ve listed a few helpful hints to keep in mind as you sort out your tax situation if you’ve made transactions using Bitcoin or other digital currencies. Failure to report these transactions on your tax return can result in penalties and interest, along with substantial fines.
In connection with a recent settlement with the IRS, Coinbase agreed to issue 1099-Ks for its customers who have engaged in at least 200 cryptocurrency sale transactions and whose total value is equal to or greater than $20,000 during a calendar year. The 1099-K is issued to the IRS as well, so the agency will be matching this information to your tax return. Of course, even if you haven’t received a 1099-K from Coinbase or another exchange, you are still required to report your cryptocurrency transactions.
Cryptocurrency Is Property
The IRS made it clear that cryptocurrency is treated as property for U.S. federal tax purposes in 2014’s Notice 2014-21. There is a large body of established tax principles and law for property that apply to cryptocurrency and how the gains, losses, income and transactions are treated for federal tax purposes.
Among other things, this means that a payment made using cryptocurrency is subject to information reporting to the same extent as any other payment made on property. Using cryptocurrency to pay independent contractors and other service providers is taxable, and self-employment tax rules generally apply. Using cryptocurrency to pay employees is also taxable to the employee, must be reported on a W-2 and is subject to federal income tax withholding and employment taxes. Certain third parties who settle payments made in cryptocurrency on behalf of merchants that accept cryptocurrency from their customers are required to report payments to those merchants on a 1099-K.
Basically for reporting purposes, cryptocurrency payments made to merchants are treated just as those made in dollars.
Cryptocurrency Is a Capital Asset
Almost everything you own and use for personal purposes, pleasure or investment is a capital asset. For examples, stocks and bonds, coin or stamp collections and precious metals are capital assets. For most, cryptocurrency will also be a capital asset.
Determine Your Crypto Capital Gains or Losses
The related gains and losses on the sale or exchange of virtual currencies would be considered capital and would be further classified as having short-term or long-term capital gains or losses. A gain or loss is deemed short term if it relates to an asset held for one year or less. A gain or loss is deemed long term for an asset held for longer than one year.
In this case, to figure if you held cryptocurrency longer than one year, start counting on the day following the day you acquired it. The day you disposed of the cryptocurrency is part of your holding period.
Know Your Capital Gains Tax Rate
The tax rates that apply to a net capital gain are generally lower than the tax rates that apply to other income. The term “net capital gain” means the amount by which your net long-term capital gain for the year is more than your net short-term capital loss. The lower rates that apply to net capital gains are called the maximum capital gains rates. For both 2017 and 2018, the maximum tax rates for individuals are 0%, 15%, 20% and up to 23.9% including the net investment income tax.
Report Sales and Exchanges of Cryptocurrency on Your 1040
The information on a 1099-K reports the gross proceeds from the transactions involving cryptocurrency but does not provide the necessary details to determine any gains or losses on the transactions. For this, each person must separately compute his or her gains and losses. Each time you buy, sell, send and receive cryptocurrency needs to be properly categorized to determine the holding period, basis and price in U.S. dollars of the cryptocurrency transaction.
Furthermore, if you exchange one currency for another, this exchange is treated as a sale for tax purposes. For instance, if you exchange Bitcoin for Ether, this exchange is a taxable event. You will need to note the value of both coins in U.S. dollars on the day of the transaction to determine the associated gain or loss.
Transfers to and from your wallets are most likely not exchanges and therefore not taxable events. The variety of transfers and transactions requires detailed record-keeping and analysis of each transaction to determine whether it was a purchase, a sale or merely a transfer. Many exchanges allow you to download your transactions, which you then need to sort and analyze to determine the nature of each and which you need to report.
Keep Track of Transactions
It is strongly recommended that you keep detailed records of all your cryptocurrency transactions. In the absence of this analysis, the IRS assumes that the entire gross proceeds reported on a 1099-K are taxable, so it is crucial to analyze and report the cost basis and sales price properly.
Once you have analyzed your cryptocurrency transactions and determined the holding period, the cost basis and sale price, you need to report this information on Form 8949. Form 8949 has separate parts for short-term and long-term transactions. Short-term gains and losses are reported on Part I and long-term gains and losses are reported on Part II of Form 8949. These distinctions are essential to arrive at your net capital gain or loss, which you summarize and report on Schedule D.
Capital losses are allowed in full against capital gains plus up to $3,000 of ordinary income. Capital losses above $3,000 are carried forward and can offset your capital gains in subsequent years.
Hard Forks and Airdrops
In October 2019, the IRS released a revenue ruling concerning the treatment of two processes: “hard forks” and “airdrops.” Both processes involve new currencies which are derived from splitting off of old currencies.
According to the IRS’s statement, “A hard fork is unique to distributed ledger technology and occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger. ”
Meanwhile, an airdrop “is a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers.” A hard fork followed by an airdrop can lead to the creation of a new currency, but an airdrop doesn’t always come after a hard fork.
The creation of new currency is important, because, according to the new rules, taxpayers do not have income as a result of a hard fork if they do not receive units of a new cryptocurrency. They do have ordinary income if they receive units of a new cryptocurrency in an airdrop following a hard fork, which means it’s taxable.
That’s an awful lot of jargon, but suffice it to say that if you wind up with new units of a currency as a result of these processes, those units will qualify as taxable income.
Be Aware of Potential Legislative Changes
With the increased popularity of cryptocurrency and its acceptance by merchants, small transactions, such as those to buy a cup of coffee or a pizza, can result in a gain or loss. That means you are currently required to report these transactions that can represent a taxable gain or loss. Proposals have been introduced in Congress to apply a de minimis to transactions such that you would not need to report transactions under $600. While it is still a just a proposal, it’s a good idea to keep an eye on any changes as it could save you time spent tracking.
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